With earnings hard to come by in a low-growth world, American companies offering sustainable revenue and earnings growth, rather than short-term fixes like share buybacks, are likely to be rewarded, argues Richard Saldanha.

 

The amount of share buybacks by US companies has surged since 2009 (see figure one), fuelled by healthier corporate balance sheets with increasing levels of cash (see figure two) and easy access to cheap debt. The low-growth environment has also played a part. With many companies struggling to find opportunities to boost revenues organically, buying back stock has become a popular means of deploying excess capital, helping prop up earnings as a result.

This may be a sensible strategy in the short-term, but is likely to be to the detriment of the longer-term prospects of businesses. Whilst companies will likely continue to generate significant amounts of cash and debt markets will remain accessible, it is questionable how much longer this buyback boom can continue. Long term investors, in particular, want to see firm evidence capital is being used productively. 

 

Are buybacks starting to lose their lustre?

For much of the past decade, companies that have engaged more actively in share buybacks (as defined by the S&P Buyback Index) have tended to outperform the S&P 500. Indeed, the Buyback Index outperformed the broader market gauge every single year between 2008 and 2014. This all changed in 2015, when the index underperformed by around six per cent; suggesting buybacks are beginning to lose some of their attractiveness. It indicates investors are less willing to reward companies that announce buybacks, and are focusing more on whether they allocate capital in the most efficient manner.

Buybacks can be destructive to long-term prospects

There are instances where buybacks can be detrimental to the long-term aspirations of companies. Among the more noteworthy examples is US tech giant IBM, which for many years has engaged in large-scale buybacks. In the ten year period prior to the start of this year, the company spent $125bn on buybacks alone; $15 billion more than it spent on capital expenditure and research and development (R&D). Although its share price performed well for the large part of this period  - more than doubling in value between 2005 and 2011 - the stock has underperformed the S&P 500 by almost 100 per cent since 2011, with IBM left behind by the slowdown in sales of PCs and the shift to cloud-based platforms. Investors have been left wondering if this $125bn would have been better spent on investing either within the business or via mergers and acquisitions to position the company better.

Activist investors turning up the heat

There also appears to be a significant relationship between the level of activist investor activity in US stocks and the level of buyback activity/capex reductions. An analysis conducted by S&P Capital IQ[1] for the Wall Street Journal showed that in the period 2003-2013, S&P companies targeted by activists reduced capex in the five years after activists bought their stock from 42 per cent to 29 per cent of operating cash flow.  The same companies boosted spending on dividends and buybacks in the year after being approached to 37 per cent of operating cashflow from 22 per cent.

Hedge funds run by activist investors have long claimed some listed companies squander money that should be returned to shareholders instead through dividends and buybacks.  Carl Icahn was extremely vocal about wanting Apple to increase its stock buybacks, writing an open letter to CEO Tim Cook in October 2014[2]. Despite Apple increasing the pace of buybacks, Icahn is now out of the stock completely, citing concerns over China. One could argue that given the worries over declining revenues from iPhones, Apple would be better off investing its surplus capital to diversify its business model rather than buying back its own shares.

Focus on capital efficiency

While buybacks are undoubtedly an important part of the capital allocation toolkit for companies; recent evidence suggests the benefits of this strategy are starting to wane. To generate sustainable long-term growth, companies need to focus on re-investing further in their own businesses. Investors have a key role to play in forcing the issue, however. Ultimately it is up to long-term shareholders, as stewards of capital, to demand companies allocate capital in the most efficient way.

 

 

[1] http://blogs.wsj.com/moneybeat/2015/07/20/clinton-to-put-activist-investors-in-campaign-spotlight/

[2] http://carlicahn.com/carl-icahn-issues-open-letter-to-tim-cook/

[3] Source: Bloomberg as at 20 September 2016

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